Look At All The Dry Powder We Still Have Lying Around, Ready To Explode During The Next Panic

The shadow banking system is essentially the world of financial
companies who don't have access to central bank liquidity or
government guarantees such as normal banks, but who provide
bank-like services.

It grew to be larger than the normal banking system itself
pre-crisis, as U.S. financial innovation ran rampant, and then
contracted particularly hard during the crisis since these
'non-bank banks' didn't have the kind of government backstops
banks do. For example, normal retail banks have FDIC guarantees
for their average retail customers' deposits, which prevent
banking runs during times of panic. Financial companies in the
shadow banking system have nothing like this and it showed them
to be particularly unstable during the crisis.

Well, a new research paper from the New York Fed shows how
despite its contraction, the shadow banking system remains larger
than the traditional one, with $16 trillion vs. $13 trillion in
assets.

It's like a giant pile of dry powder still lying around, ready to
blow up during the next financial crisis:

The subprime crisis may have started the fall, but the
financial crisis was precipitated by a run on shadow
banks. As this paper shows, there is an inherent
weakness in the shadow banking system that makes it vulnerable to
future bank runs.

...

For shadow banks, the bulk of the deposits are provided by money
market funds. These funds expect their deposits to be available
on demand and at par. But the implicit put option, at par value,
is not backed up by any capital or official enhancement
whatsoever.

From the perspective of the shadow banks, their funding sources
are not as stable as retail cash balances. As the authors point
out, institutional cash balances, such as those of corporations
and municipalities, are well-informed but exhibit herd-like
characteristics. Any entity that relies on them for funding and
lacks alternative sources of liquidity is inherently fragile.
During times of crisis, if confidence in the credit puts
guaranteed by the institutions erodes, depositors move to redeem
their funds. Absent a backstop, in the form of government
guarantees, a run on the system ensues.

So basically, we haven't changed much. Our financial system
remains vulnerable to another credit crunch, with many of the
same exact features as the last. All it needs is someone to
strike the match of panic.

The hard question is how to deal with the chart above. Regulate
shadow banking more tightly, and you probably have to also
provide government backstops. Shudder. Try to shut the thing down
or restrict it and you suck credit out of the system, credit
which much of the non-financial 'real' economy uses and needs.

So it's clearly not an easy situation, and somehow I feel that
we'll all just sit and do nothing since hard decisions usually
end that way. Even the New York Fed paper referred to above says
that it doesn't want to take a position on the regulatory issue.
Everyone's on the fence, watching the powder dry.